Refinance Free Credit

Understanding Wall Street (Mortgage) Losses

We’ve all been reading about the massive losses at most all the major Wall Street investment banks and commercial banks, but let’s understand how most of these losses are generated.

Merrill Lynch has written off around $22.4 billion in mortgage related losses (so far). Anyone who has dealt with Merrill Lynch’s mortgage division, Merrill Lynch Credit Corporation (“MLCC”) understands that MLCC was one of the most conservative mortgage lenders on Main Street. MLCC was a joint venture between Merrill Lynch and PHH Mortgage, another lender I’ve always respected. The only loans they originated were full doc, high FICO, low LTV, high asset borrowers.

The Merrill mortgage bankers were the something that we could all strive for in our professional lives. I had lunch with Larry Washington, the President of MLCC who told me that one of the reasons MLCC was so conservative was that “you’ll never get hurt originating a quality loan.”

Do you think that the vast majority of investors, mortgage lenders and originators feel that way now?

So how did Merrill Lynch lose $22.4 billion?

If you’ve ever had the privilege of dealing with a Wall Street investment banker you’d remember as you’ve been in the grace of a god-like human. Armed with MBAs from the elite B-Schools, investment bankers and hedge fund managers had egos larger than their wallets.

The former “Masters of the Universe” are no longer masters of their own domain (Seinfeld joke). Investment bankers were not concerned with risk (or potential losses), but rather profit, on which they earned their annual bonuses.

There’s a word on Wall Street called “leverage” that works beautifully when your investment goes up in value. However it becomes a nightmare when the investment turns south.

In simple words “leverage” means borrowing, much like “margin” with stocks, to purchase part of your investment. This is similar to a real estate mortgage, except with leverage the lender must always maintain their initial lending percentage of the current market value.

Say I’m a Wall Street firm and I want to purchase $100 million of mortgage securities such as CDOs (Collateralized Debt Obligations) then yielding 8%. My $100 million of capital earns $8 million for an 8% rate of return.

However if I use leverage I can purchase a whole lot more securities with my same capital. Back then I cold have borrowed collateralized capital at 3% and invested in the same subprime CDOs earning 8%.

Instead I purchase $200 million of mortgage securities CDOs and have the bank lend me $100 million. If my borrowing cost is 3% and I’m making 8% of my investment I’ve just made an easy 5% of free money.

That’s $5 million net profit from the $100 million I’ve borrowed from the bank plus my $8 million from my own $100 million of capital. So I just made a 13% net return on my $100 million capital. That’s a whole lot better than U.S. Treasuries paying only 2-3% at that time. Follow me so far?

I got some choices here — I can pay $100 million cash for my CDO investment OR I can have 50% leverage (AKA: 2x leverage) with my 50% cash equity position and 50% borrowed collateralized capital.

Isn’t this country great!

But why stop there? Why not only put up 10% of my own capital and borrow the 90% from the capital markets? Now my $100 million capital would control $1 billion of CDOs and earn a net profit of $53 million for a – get this – 53% rate of return on bonds.

We should all be hedge fund managers making a $1 billion a year.

Alas leverage is a double-edged sword. That bank I’m borrowing the 50% loan from will always demand that their debt position is never greater than 50% of the current market value of the securities that I’ve purchased.

But what happens if the value of my $200 million mortgage securities portfolio declines, much like what has happened recently in the mortgage securities market?

Let’s say that the value of my $200 million mortgage securities portfolio declines by 10% to $180 million. Now the bank who lent me the initial $100 million loan demands that they are kept in a 50% equity position. 50% of $180 million bond valuation is $90 million. So now I have to come up with $10 million in cash to pay to down the bank margin at the same time my investments declined by 10% (or $20 million).

Ouch!

That’s with only 2x leverage. Many of the Wall Street firms and hedge funds had 5x, 10x, even 13x leverage on their mortgage security portfolios.

That means I only put up $100 million of my own cash to purchase $1 billion of mortgage securities. The other $900 million came from the bank(s) lending me 9x leverage.

Let’s look at the same scenario – my $1 billion mortgage securities portfolio declines by 10% to $900 million. The bank will initiate a margin call to maintain their 90% loan of the current market value. That means the bank will reduce their loan exposure to $810 million (90% of the $900 million current market value).

Now I have to come up with $90 million in additional cash (or liquid marketable securities) to the bank while at the same time my portfolio declined by $100 million in market value.

Even though the mortgage securities portfolio declined by only 10% ($1 billion to $900 million) thanks to leverage, my initial investment has lost 90% ($90 million bank margin call).

To put things in perspective the ABX subprime indexes have declined from a price of 100 to 65 since July 2007. God forbid those investment bankers and hedge fund managers (who are so much smarter than you and I) had any leverage to their mortgage portfolios.

This has been rather common around The Street over the past nine months as investment bankers have been trying to unwind, or in some cases – “don’t sell, don’t tell” as many of the CDOs do not have an active market on which to set a daily price. In other words, if no one sells, then no one has to mark down the value of their mortgage security portfolio. The problem comes when any investor sells a block of CDOs, then the entire market is supposed to “mark” their CDO portfolios to the new market price.

This is how Bear Stearns lost 100% of the value of two of their hedge funds last year.

Nobody is buying or selling any sort of esoteric loans on Wall Street right now. Another reason why the mortgage market has frozen up for jumbo, Alt-A and subprime loans.

Ask Countrywide, IndyMac, First Fed, Downey, etc. etc.

The good news is we’re back to a conforming and FHA/VA mortgage market. Personally I can’t fathom having 1 out of 10 of my clients going into default. Heck, in any one year if I have 1 out of 100 clients going into default then I feel I didn’t do my job in consulting and advising their of their options and the risks involved.

Some more good news. The wife and I had some great filet mignons and shared a bottle of 1999 Clos Du Bois Briarcrest Cabernet Sauvignon at dinner tonight.

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I don’t really want to pull discussions away from Morgan’s thoughts about a fool’s rally because I think he’s got a very good handle on things.   I’m in a market (western Michigan) where we’ve seen a lousy market for a couple of years, but we didn’t have the outrageous price increases that other areas saw (like where Morgan lives).   So, correspondingly, we aren’t seeing the huge decreases that other areas did.   So, if someone is looking at buying a house in my area right now, I’d say that they need to:   1) Plan on holding for at least 5 years,  2) Know the specifics of their portion of the market so that they don’t over pay and 3) If they don’t need to buy now, they should wait.

So here’s the latest on what’s happening in the mortgage/real estate/financial worlds:

1. Banking - Citigroup, Merrill Lynch, Chase, First Horizon and Washington Mutual all reported earnings that were either way down (Chase) or actually losses (everyone else) and the amount of write downs that they took were truly staggering due to the amount of $000’s left of the decimal point.  Remember a write down is where they say that the value of their assets isn’t worth what they thought that it was and that raises some significant capital (cash) issues for banks.

2. Retail sales for December were not nearly as positive as had been hoped for. 

3. Housing starts were down 14% nationally in December.  Let’s put it this way, 3 of my 5 kids weren’t even born the last time housing starts were at that level and one of them is getting her driver’s license in May.

4. The Federal Government is making a lot more noise about a “stimulus package” to try to keep the economy going and avoid the “r” word during an election year.   The true nature of the package and it’s effect on the economy are far from clear at this point.

5. The Feds Funds Futures market is now pricing in a very good chance (that’s a scientific term) that the Fed will cut rates by .75 % when they meet on the 29th and 30th.  There is even a fair amount of people on Wall Street who think that the Fed might cut rates by a full 1%.

So what does that all mean?   A couple of things:

1. If you’ve been following the market for any length of time and reading any of my “stuff,” you know that comparing what the Fed does to mortgage rates is like comparing apples and oranges.   The fact that the Fed is lowering short term rates doesn’t mean that long term rates will move down by the same amounts or frankly even move down at all.   Why not?

    a. They truly are two different financial animals.   What the Fed controls are the “overnight” rates that banks can borrow from the Fed on.    What we pay more attention to are the long term (10 year and beyond) rates.

    b. As we’ve all seen, the profitability of the secondary mortgage market (Fannie Mae, Freddie Mac etc.) isn’t what it should be, so I think that as some other rates fall, we’ll see a widening of “profit margins” on mortgages that will prevent mortgage rates from falling as far as other rates do.

    c. Looking back over the last few years, I remember when prime (currently 7.25%) was at 4% and mortgage rates were in the low 5’s.   Now, prime is soon to drop to at a minimum 6.75%, but mortgage rates are only in the upper 5’s. 

    d. The perceived inflationary risk of lowering short term rates - why are they lowering short term rates?   Frankly to boost the economy and keep it out of a recession.   If they succeed, then as the economy starts picking up, inflation becomes more of a risk.

So, we’ll have to see what happens, but I’m not anticipating a substantial move in mortgage rates in the next couple of weeks because of the Fed.

2. Using the baseball game analogy, how far into the game are we?  Well, with the sale of Countrywide to Bank of America, and rumors that Chase is looking at buying Washington Mutual, I think we’re a little farther along, but probably still only in the top of the 4th inning.   There are a lot more issues to uncover in mortgage portfolios, a lot more adjustable rate mortgages that are going to reset, and a lot more bank owned homes that need to be cleared off of inventory before we get to the bottom of this.

3. Underwriting guidelines - I’m starting to get a “feel” that we’ve probably seen the majority of the underwriting changes that are going to happen.   UNLESS (big IF) the mortgage portfolios start performing even more badly (worse?) than they are, going forward what we’ve got to work with now is looking like it’s what we’re going to have to work with.   Frankly, that’s not a bad thing.   The majority of the loans that I can’t do now (that I could 9 months ago) are ones that frankly probably shouldn’t be done.

A couple of other thoughts:

1. The Bank is closed on Monday in observation of Martin Luther King Jr. Day.   I think it’s a good time for us all to take a minute and admire a man who stood up for his principles and fought for what he believed in.

2. If you’d like to learn a little bit more about me and what keeps me busy when I’m not writing mortgages (and sending e-mails about the mortgage business), check out the article that I wrote for Focus on the Family’s website.   You can find it at: http://www.icareaboutorphans.org/Default.aspx?Menu=7&Article=20.

We aren’t done with this, not by a long ways.   That’s why it makes sense to continue to listen to people like Morgan and take the time to read the comments on this blog and others.   There’s a lot of collective wisdom out there that can help you either make wise decisions on how to navigate through this mess or how to decide when it’s time to get out.

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Closing costs can be one of the most frustrating and confusing aspects of refinancing your mortgage. Settlement charges are rarely explained and vary widely from lender to lender. How do you know that the settlement charges listed on your Good Faith Estimate are accurate and fair? Are ...